"We're In-The-Money"

By Brent L. Leonard

The following investment strategy is one that is more defensive and has lower risk
than the overall stock market. It compares the hypothetical results of investing in
the stock market (Plan A) to my New Normal way of investing (Plan B), in quality
dividend-paying stocks (3% or more), combined with a conservative covered-call
option plan that not only brings in additional money, but provides up to a 10%
Safety-Net on the market! Once in a while the right investment plan comes around
at the right time - in my view, this defensive plan for an unstable economic
environment is the right one for now.

Current Conventional Wisdom, including some of the most reliable analysts, are
now calling for a 10% rise in the stock market over the remainder of 2010. This also
represents the average gain of S&P 500 -type stocks over the past 100 years. As a
Contrarian for many years, I am suspicious of this rosy scenario.
Below are several different possible scenarios that stocks could undergo:

Scenario #1: The market does what the analysts prognosticate -rises 10% in the next
12 months.

Plan A: Investing in an Index fund, market ETF or portfolio of stocks, makes

@10%, plus some dividends.

Plan B: Combining the 3% dividends and time premium from in-the-money

covered call options @10% below the buy price of the stock or market has
consistently yielded 10% over the brief time of a year and several types of markets.

Scenario #2: The market stays flat for the next year, after a 70% run up the past 12
months - this also mimics the past decade which saw a slightly negative return.

Plan A: Investment return would be just about zero, with some dividends.

Plan B: New Normal plan would still receive the 3+% dividends plus option
premiums, for @10% return. (It is a non-directional strategy not relying on the
"hope" of appreciation which so often disappoints.

Scenario #3: The market drops 10% in the next year.

Plan A: Investors are torn between trying to hedge with decaying puts, not
knowing when to cash them in if profitable; or they have been nervously shaken out
of their positions by the "fear" of losing more.
 Plan B: Participants in this plan have "pre-sold their stocks 10% below their
buy price, at the time of purchase, with delivery at expiration in about 6 months
from entry. They still receive the above 10%, profiting that much. Not only that, but
future purchases will be at lower prices, making dividend %s higher; also, option
Volatility (read prices) also go higher in falling markets, e.g. VIX.
Example: Investor B buys a stock at $30 and sells the 27 call ($3 or 10% lower); if
the stock eventually falls to $27 they are still ahead, and can even now sell the 25 call
for 6 months out, with a higher dividend yield and probably more option premium.

Scenario #4: This event is the only downside to the New Normal plan, -the Black
Swan dive! A Bear market of 20% or more would result in a loss, although one
should have time to plan either an exit or hedging strategy, realizing that 100% of
the time, especially recently, markets have snapped back up and gone higher.

Plan A: Investors who bought-&-held would suffer the entire loss of the
market.
Plan B: Again, with the 10% Safety Net, still getting the usual income, NN
investors would break even at 20% down, possibly riding out the ensuing market
with more covered calls, buying more stocks with higher dividend yields.

Since 1903 there have been 1 or 2 Bear markets each decade, with 5 as much as
down 50% - average number of months was 22, per the U. of Chicago.. In a cycle
study I wrote about years ago, and recently covered by Martin Pring's Lost Decade,
since 1790 generational cycles (18-19 years) have alternated between Bull markets
(e.g. 1982-2000) and flat to down cycles (1966-82). After the largest Bull market in
history ending in 2000, it would be prudent to defensively assume a continuation of
the flat market we just endured until near the end of the current decade; especially
of one can get a double-digit return as shown with Plan B above.

The only other scenario would be another huge Bull market, wherein the NN
investor would still get their 10% or more, plus a widening margin of Safety Net as
their stocks rise. Also, what may be initially conceived of as a flaw in this theory is
the premature "calling away" of the stock by what is known as a dividend-play,
where the call option is exercised early - I found this condition results in nearly
twice the annualized return, due to the shortening of the option period -even
without (ex) the dividend itself.

Despite the attractive return in today's grim economic environment, this is basically
a "Defensive", conservative strategy! If one factors in the 10% pre-sold amount
coupled with another 10% annualized gain, even if the rare Bear market of 20%
occurs, they would still not be at a loss, while Index funds, etc. would be at 20%
under water, trying to decide whether to cut and run or wait it out. According to the
above study by the University of Chicago, the average Bear market since 1903 was
negative 22%, although the larger numbers have occurred more recently, thanks to
increased leverage (1987, 2002 and 2008); only 5 were greater than 40% and usually
snapped back up quickly.
Using the "Doubling Rule of 72", where 72 divided by the percentage gained
dictates the number of years it takes to double one's money, if the Bear market did
not occur for 7 years, they would have doubled their money, using "house money"
in the future years. Compare this to current MMF rates of .01% which would take
7,000 years to double!
I hope the reader can rid themselves of the heuristic conventional fear of "options"
enough to avail themselves of this strategy with at least a part of their assets - that
portion getting zero to negative interest in short term rates for an extended period.
In my 25 years as a professional and private investor, I cannot think of another
strategy so devoid of Risk as this, except, of course, negative-return government-
backed products.

For more information on the New Normal, please see: http://www.brentleonard.com

I would be more than happy to entertain any comments or refutation of this premise.